by Sean Ross, Editor-in-Chief, Financial Poise
BUSINESS RELATIONSHIPS FAIL for lots of reasons. Even when a business is successful, its owners may clash over any number of issues.
Breaking up is hard to do, but there are things business owners can do to prepare themselves. In this article, we’ll cover:
Conflicts between the owners of closely held businesses are common, at least relative to many other business structures.
Concentration of control, particularly in family-owned businesses, is a major contributor to internal strife. So too are lack of effective corporate governance structures and lack of liquidity to deal with owners wishing to exit.
Closely held businesses must also contend with minimal distinction—legally and operationally—between owners and the business. Finally, many closely held businesses fail to clearly state withdrawal and dissolution rights.
Businesses fall apart for one hundred different reasons—you can’t safeguard against all of them all of the time. Focus on the most common problems and guard against them, including:
Majority Control and Shareholder Oppression
In many businesses, one owner (or group of owners) controls a majority of the business’ equity—this is particularly prevalent in closely held companies.
Often times, this creates a situation in which one decision-maker wields more influence than the many minority shareholders. Such concentration of power can lead to oppression of the minority shareholders by the majority owner.
A majority group of shareholders may breach its fiduciary duty if it uses its voting power to withhold dividends inappropriately. Often, this is a tactic to force minority shareholders to redeem their shares (i.e., force them out at a low buy-back price).
On the flip side, the majority may also breach of a fiduciary duty by declaring an unreasonable dividend that depletes the corporation’s cash reserves.
Sale of Business
A majority may breach its fiduciary duty if it hinders the sale of the corporation inappropriately. In other words, it does so without considering, or in frustration of, the liquidity needs of the minority
Terminating a Shareholder-Employee
If a minority shareholder is an employee of the business, she or he may have a reasonable expectation of employment. A majority shareholder may breach her or his fiduciary duty by terminating that employee.
Other Common Problems
The expression “an ounce of prevention is worth a pound of cure” is apt.
Conflicts between business partners are nearly inevitable. Thankfully, there are a number of ways for parties to negotiate up-front. Precautionary agreements give you space to resolve issues more easily or, at least, provide a picture of what the result will be when resolution is not possible.
IMPORTANT: Discussion should happen early, at formation. Always memorialize these discussions in a written agreement.
To analogize, think of these discussions as a prenuptial agreement; a business divorce is often similar to a marital divorce. A well-drafted partnership, shareholder or operating agreement can prevent—or at least potentially resolve—a deadlock.
Provisions to include in such agreements include:
A buy-sell agreement typically obligates the company or remaining its majority owners to purchase the minority’s stock in certain events. Negotiating one, however, is often difficult.
When a business has two owners, one common solution is a “shotgun” provision. This triggers a mandatory sale in the event of disagreement and deadlock.
Getting more granular, you could also provide both shareholders the right to offer a specific price per share for the other shareholder’s shares. The other shareholder then has the option of accepting the offer or buying the offering shareholder’s shares at the price offered.
State laws provide a variety of options to help shareholders address their disagreements.
Delaware, for example, permits a court to appoint a custodian for a solvent corporation when:
Mediation and arbitration are options that enable a neutral third party (other than a court) to resolve or help resolve disputes.
Finally, if there is no other option, a company can be dissolved because of disputes that cannot be resolved. Indeed, a dissolution provision may be included in a company’s articles of incorporation or operating agreement.
You have a dispute and the other strategies haven’t worked. What next? You can always take the legal route, but litigation is expensive and time-consuming.
Any good professional will advise that that where a dispute can be settled without litigation, it should be.
Which path you take will, in large part, be a function about whether you can trust your partner. Sometimes reasonable people disagree, but neither party doubts the other party’s honesty and reasonableness. Settlement is often possible and always the better route in such cases.
On the other hand, if you believe the other party is objectively unreasonable or dishonest, then trying to settle with that person is likely to be a waste of money and time.
Financial Poise Webinars is the leading source of practical, entertaining education for investors and private business owners/executives.
To view a Financial Poise Webinar that goes into much more detail about this topic—Common Issues and Strategies in Business Breakups—click here.
The expert panelists for this webinar are:
Erin Hollis, Financial Valuation and Consulting Director at Marshall & Stevens Incorporated
Jud DeLoss, Officer at Greensfelder, Hembker & Gale
Katherine Puffer, CPA, ABV, CPCU at VH Valuations
Leland Chait, Partner at Sugar Felsenthal Grais & Hammer
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The material in this article (and associated on-demand webinar) is for informational purposes only. It should not be considered legal, financial or other professional advice. You should consult with an attorney or other appropriate professional to determine what may be best for your individual needs.